ECB experts: “Climate change increases the cost of debt”

Brussels – Climate change, with extreme weather events such as droughts and floods, is placing an increasing burden on public finances and “can push up the cost of debt,” European Central Bank (ECB) experts warn, which risks being a problem especially for highly indebted countries, like Italy, and developing ones. In short, those who struggle to grow and prosper risk staying stuck, and governments that can’t keep their public accounts in order are increasingly likely to see them remain in disarray.

 “Climate change poses risks to public finances through various channels,” according to the special report published on the ECB blog. First, it explains that adaptation and mitigation measures may demand “higher public spending.” Alternatively, governments may “have to divert resources from productive investments” to new technologies that mitigate climate change. Furthermore, “the effects of climate change may weigh on prices of sovereign bonds“. It means that buying government bonds can become less attractive if their price falls; with fewer buyers, the country struggles to cover its debt because it sells fewer bonds, and yields may rise, meaning the state must pay investors more when the bonds mature. This is, in essence, where the direct pressure on sovereign debt is strongest.

By way of example, the ECB report explains that in the event of flooding, highly indebted countries such as Italy could even initially see lower yields, reflecting expectations of external support and short-term emergency financing. However, “as fiscal pressures accumulate, yields begin to increase and remain elevated, signalling rising risk premia,” and, therefore, a larger repayment to the buyer by the state, with negative consequences for state coffers.

 https://www.eunews.it/2023/10/06/rifugiati-climatici-aumento-problema-ue/ 

The pressure on debt is illustrated in cases of responses to storms. Here, high-debt countries record the largest and most persistent yield increases in the ECB’s reference sample, with an increase in sovereign debt yields of around 22 per cent, equivalent to around 66 basis points for a typical advanced economy with an average ten-year yield of 3 per cent and over 140 basis points for a typical emerging economy with an average ten-year yield of 6.4 per cent. 

Additionally, in the event of natural disasters, the cost of emergency assistance and post-disaster reconstruction can have a direct budgetary impact in the form of increased public spending, while indirect effects may include lower tax revenues caused by production disruptions or additional spending on food and energy support systems as a result of changes in commodity prices.

 All of this shows that “high-debt countries are less equipped to manage the impacts of severe weather events” alongside the financial and fiscal demands of the green transition. As a result, policymakers at the national and the EU level “must deepen their understanding of how transition efforts affect borrowing costs and intensify their international efforts to address both climate and sovereign debt challenges.”